Typically, car accident settlements are not taxable. According to the Internal Revenue Service (IRS), “If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income.”

However, there are certain exceptions to this rule. It is important to consider tax when negotiating with the at-fault driver in order to keep as much of your settlement as possible.

Is My Car Accident Settlement Taxable?

When it comes to looking as the taxability of your compensation, you need to observe the reason for the payment – lost wages, replacement or repair of damaged property, medical costs, pain and suffering or wrong-doer punishment.

What Part of My Auto Accident Settlement Is Taxable?

So how exactly does settlement money get taxed? When looking at a settlement, certain elements are taxable and include:

Payments for lost wages or lost profits

Interest on any settlement

Most punitive damages

Damages for emotional distress

Lost Wages

Lost wages compensation replaces what you would have earned working. In the instance you don’t make a complete recovery, you may also receive compensation for future lost wages. Wages are taxable, which is why lost wages are also taxable.

Taxation for lost wages can be a bit complicated, as you could be taxed for several years of income for the year you receive a settlement. This sometimes results in a higher rate. For example, let’s say you earn $37,000 a year and are taxed at a 15 percent rate. However, you receive three years of lost wages in your settlement. This means you’re now paying taxes on $111,000, which taxes you in the 28 percent bracket.

Keep in mind that if you are working with an attorney, you have to pay taxes on the entire settlement, even though an attorney on contingency typically receives one-third of your auto accident settlement. In addition, you receive a 1099 from the defendant (not a W-2), which means you are responsible for the employer’s part of Social Security and Medicare taxes.

Car Accident Medical Damages Aren’t Taxable

Payment for medical treatment is tax-exempt, with an exception. According to the IRS, “if you receive a settlement for personal physical injuries or physical sickness, you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit.

If part of the proceeds is for medical expenses you paid in more than one year, you must allocate on a pro rata basis the part of the proceeds for medical expenses to each of the years you paid medical expenses. See Recoveries in Publication 525 for details on how to calculate the amount to report. The tax benefit amount should be reported as ‘Other Income’ on line 21 of Form 1040.”

You can only deduct medical expenses that exceed 10 percent of your adjusted gross income (7.5 percent if you’re 65 or older), unless you deducted your medical expenses in a previous tax year.

Car Accident Pain And Suffering Treatment Varies

If you are experiencing pain and suffering as the result of a physical injury, your compensation is not taxable. However, if your pain and suffering falls under emotional distress, your compensation is taxable.

For example, let’s say you are in a car accident. Although you are not suffering an injury, you develop a fear of driving and being on the road. This emotional distress is taxable. However, if your accident causes an injury and you experience emotional distress due to the injury, that distress is tax-exempt.

Reducing Your Accident Settlement Tax Obligation

With the help of a skilled attorney, there are a couple of ways to reduce or eliminate your settlement tax obligation.

Structured Auto Insurance Settlement – Avoid taxes and receive the money in installments. Known as a “structured settlement,” this allows you to exclude some of the income from current taxes.

Classifying Damages – There are two categories of damages when you sue another driver – general damages and special damages.

Special damages are easy to quantify and include lost wages.

General damages are more subjective and include pain and suffering.

Achieving a tax-friendly settlement can ensure you walk away with the compensation you deserve.